Sovereign debt crises and their implications for currencies

The evolution of currency has been marked by several milestones. The use of commodity money, for example the use of objects such as shells, was followed by the minting of standardized coinage, usually from precious metals, and later by the adoption of representative money, which refers to money that consists of a token or certificate (legal tender).

Today, we operate in a world of 'fiat' money, which is money that is not backed by reserves, but which is given value by government decree or 'fiat', meaning literally "let it be done". Essentially, 'fiat' money is dependent upon faith, as its nominal value can be debased, unlike that of physical commodities. This fiat enforces legal tender laws, by which debtors are legally relieved of their debt if they (offer to) pay it off in the form of the government's money.

The integrity of fiat money is likely to continue to be tested over coming years. Its credibility rests on the issuing governments; if investors perceive a government's finances to be shaky, the value of that government's currency, and that of its 'fiat', is likely to fall. There are times when higher interest rates can support a currency, but if rates are too high (thereby undermining economic growth and reducing government revenues), they can serve to weaken the value of the currency.

Currency markets are influenced by different trends, which ebb and flow over time. One of the key trends affecting the euro recently has been concern about the scale of peripheral European sovereign debt. The draconian austerity measures being undertaken by European governments in response to their fiscal crises are perceived to run the risk of causing a 'double-dip' in economic activity. By comparison, the comparatively relaxed attitude of US policymakers has led investors to conclude that growth may be stronger in the US in 2010 and 2011. As with other fashions in the foreign-exchange market, these sentiments could change later in the year, especially if US growth continues to show signs of slowing, and if investors place greater emphasis on governments' capacity to tackle budget deficits than on their ability to achieve relative economic growth.

If the Europeans are successful in reducing their debts and avoiding another recession, investors' attention is likely to turn to the lack of progress being made by the US in doing likewise. The short-dated profile of US government debt is likely to be a particular area of focus, as the administration must refinance US$5 trillion of debt, the equivalent of a third of US GDP, over the next 18 months. Unlike the UK, it will have to rely heavily on overseas investor support to do so.

The global credit 'crunch' and ensuing economic slowdown around the world have caused commentators and investors to re- examine their understanding of economic theory. At present, a contest of economic theory is taking place between nations that uphold 'Keynesian' economic principles, that the global economy is too fragile for governments to be withdrawing fiscal stimulus (most obviously the US) and those who follow the 'Austrian' School of economic thought, which sees budget retrenchment as imperative (for example, Germany). The debate about the respective merits of these approaches is likely to continue as authorities seek to address their fiscal and economic challenges. Keynesian economists advocate active policy responses by governments in the targeting of economic stability. Conversely, economists of the Austrian School support a laissez-faire approach, and argue for minimal government involvement in the economy.

The success or failure of these respective approaches is likely to be instrumental in determining the value both of currencies and of underlying asset markets in Europe and the US. Neither region's central bankers seem likely to tighten monetary policy in the near future and both remain vulnerable to a 'double dip' scenario. We therefore advocate avoidance of both the euro and the US dollar.

Beyond those regions, influences upon currency markets are more muddled, not least following China's decision to seek more 'flexibility' in its exchange-rate policy. This flexibility is not a 'one-way bet' on the strength of the Chinese yuan against the US dollar, although the historic relationship between the two currencies does suggest that the yuan is likely to appreciate against the dollar over the longer term. In the near term, if the euro were to fall significantly against the US dollar, China might conceivably allow the yuan to fall in value against the dollar (in order for the country not to lose too much competitiveness in relation to one of its biggest export markets). However, should it continue to fall, the political backlash from the US and from some of the Asian countries would probably be immense.

The accepted wisdom among market observers is that authorities that pursue fiscal austerity, while keeping monetary policy loose (perhaps even by renewing their use of quantitative easing measures, through which authorities buy bonds to try to invigorate bank lending and thereby lower overall borrowing costs), will see the value of their currencies decline. A lack of interest-rate support and reduced economic growth could be seen as a sign of weakness by foreign-exchange fashion followers. However, investors have withdrawn a considerable amount of money from regions where their worries about sovereign credit quality have been most acute, and they have redeployed their funds by buying the US dollar, the Japanese yen and the Swiss franc. It is possible that those funds may return to troubled nations once investors become more confident that fiscal deficits are being reduced.

In a previous article, we suggested that the current economic situation was reminiscent of the inter-war years of the early twentieth century, when countries such as France and Germany devalued their currencies against gold, while the UK and the US soldiered on with the same exchange rates. The result was a divergence in the economic fortunes of those countries. Germany experienced rapid economic growth, fed by foreign loans, which ultimately led to hyperinflation. France experienced a milder version of Germany's fortunes, with less reliance on foreign loans. Meanwhile, the UK re-pegged sterling to gold at an exchange rate that was clearly too high, and the country faced several years of deflation and high unemployment as a consequence. Only the US was able to come through that period with an economy unhampered by an inappropriate exchange rate.

The current debate about the world's economic challenges focuses to a great extent upon whether removing fiscal stimulus now will result in another economic crisis, or whether it will serve instead to ensure economic stability. The UK and several European nations have embarked on a path of Keynesian fiscal austerity, which threatens fragile economic recoveries. It is therefore imperative that central banks in those nations provide the liquidity required to counteract the effect of fiscal tightening.

We believe that the euro remains overvalued and that, despite the eurozone's mix of loose monetary policy and tightening fiscal policy, the single currency will remain under pressure, until economic stability in the eurozone is more assured. However, once it is clear that European economic growth will be positive (albeit low) and that fiscal deficits are under control, the euro could, temporarily, rebound. This would represent an opportunity to sell the euro and buy currencies that have a better fiscal position, stronger growth prospects and probably higher interest-rate support - for example Asian and commodity-based currencies, such as the Singaporean dollar and the Swedish krona.

The US has voiced its concerns about reducing fiscal stimulus too early, but it has embarked simultaneously on a form of fiscal austerity at state level. Owing to the legal requirements of states to balance their budgets, individual states have had to begin to reduce spending and raise revenues this year. State-level pay freezes and increased sales taxes are being put in place even as the federal government lectures the Europeans about the dangers of fiscal tightening. Furthermore, the US is introducing a bank levy and, in the absence of further tax measures, there will be increases in taxes once the tax cuts put in place by President Bush expire early next year. Admittedly, these changes are not as large as those being carried out in Europe, nor are they taking place so quickly; but, equally, neither do they represent a fiscal stimulus.

The US dollar may be vulnerable once financial-market participants are comfortable that the European nations are able to cut their budget deficits. Against other currencies, including commodity-based currencies and those in the Asia-Pacific region and emerging markets, the dollar could be more vulnerable, as US economic activity slows investors worry about the extent of the further deleveraging (repayment of debt) required in the US economy.

The Japanese yen appears less overvalued than the euro, but the currency faces a more significant fiscal hurdle. At some point, Japan will exhaust its supply of domestic savings and will need to resort to selling overseas assets to fund its deficit. There may be support for the yen from Japanese investors' sales of overseas assets (given the repatriation of yen that such sales imply), but the low yields of Japanese government bonds are unlikely to attract demand from overseas investors.

Other Asian and emerging-market currencies should benefit from stronger economic growth in relation to the developed Western economies. As a result, they should have a currency-supporting combination of tight monetary policy and neutral (or loose) fiscal policy.